A stock market paradox? Fed taper followed by a rally

US Federal Reserve Chairman Ben Bernanke responds to reporters during his final planned news conference before his retirement, at the Federal Reserve Bank headquarters in Washington, December 18, 2013.

The “Fed’s taper decision signals end of era for easy money” blares the Financial Times headline, the day after the U.S. stock market has risen to record levels following the taper announcement. Wasn’t the much-maligned QE that the Fed has begun to taper/reduce supposed to be causing a stock market bubble? So why does starting to take it away trigger a sharp stock market rally?

There are three reasons for the apparent paradox. First, although the Fed nominally reduced asset purchases from $85 billion per month to $75 billion per month, it indicated additional easing through two alternative and more effective channels. It raised the bar for boosting the federal funds rate to “well past the time the unemployment rate declines below 6.5 percent.” That means a threshold at least as low as 6 percent, down from the 6.5 percent previously indicated. Also, the Fed increased its focus on the persistent disinflation plaguing the economy (core PCE index has dropped to a 1.1 percent year over year pace, well below the Fed’s preferred 2 percent) by emphasizing for the first time that the reduced unemployment-rate-tightening threshold will be maintained for longer “especially if projected inflation continues to run below the committee’s 2 percent long-run goal.” The additional emphasis on a potential deflation threat was underscored by a dovish dissent by Boston FRB President Eric Rosengren who vted against the modest taper as a “premature” action.

Second, a positive aspect of the Fed’s December 18 announcement and the following press conference conducted by Chairman Ben Bernanke was a reduction in policy uncertainty. Markets, households and firms now know that the Fed is encouraged by economic performance and that if it remains so, tapering will continue. In addition, the Fed is now clearly more attentive to deflation risks of which it had been somewhat dismissive. It will require a lower unemployment rate, down from 6.5 to at least 6 percent, to trigger a higher federal funds rate and more serious tightening. Markets also know that if the economy weakens again or deflation approaches, the tapering signal will be reversed or the unemployment-rate-tightening threshold will be lowered further. Of course, whether or not such measures would help the economy remains an open question and there lies an ongoing problem for the Fed.

The third and final reason for the market’s positive initial response to taper is surprising. As my British friend and colleague, Andrew Hunt has pointed out — Fed and American commentators take note — so far in 2013 the Fed’s actual monthly purchase of bonds — the size of QE — has averaged $94 billion, or $9 billion above the advertised pace of $85 billion per month. Yet apparently no one has noticed and the Fed hasn’t advertised the extra QE . If no one noticed the gap, apparently a $9 or $10 billion difference in QE is no big deal.

One wonders what all the fuss over a nominal $10 billion QE cut is about. In fact, if markets require it, the Fed apparently will keep QE at $85 billion, notwithstanding the nominal advertised $75 billion figure. With the average 2013 monthly increase in M2 liquidity well below the monthly QE average, the money multiplier remains well below one, driven down by the banks’ unwillingness to lend. That unwillingness is understandable in view of persistent regulatory pressure for banks to boost reserves coupled with weak loan demand.

Where to next? If disinflation continues to drift toward deflation, the demi taper will fade from memory, more easing will be required, and interest rates will fall again while stocks struggle. Perhaps the big surprise of 2014 will be “the great rotation” from stocks back into bonds. Now wouldn’t that be a shock!